Save Article

The Meltdown's Legacy Still Lurks

Banks are raising capital, but a solution for toxic assets remains elusive.

By

David Weidner

Updated July 2, 2009 2:39 p.m. ET

Our nation's financial house was set ablaze by the subprime mortgage crisis, and it would have burned to the ground had the federal government, playing firefighters with more than $1 trillion in aid, not doused the inferno.

Now a smoldering heap, the worst may be over, but the house is far from safe. Trash is strewn about. Weeds choke an overgrown yard. The plumbing and roof leak. The wiring is frayed and overloaded.

And yet, despite the damage, we continue to value that asset at something above its dilapidated, run-down value.

Nowhere is the disconnect more evident than in the government-run Public-Private Investment Program, which is expected to take a step forward this week when the program's asset managers are picked. There's mounting evidence that the government-backed auction won't be anywhere near as effective in valuing assets as had been hoped when it was unveiled in March.

Big banks worry about having to sell at fire-sale prices while small banks fear they'll be shut out. Potential buyers may balk at the risk of doing business with the government, fearing politicians will demonize them for making big profits.

Some banks are reportedly using a "pray and delay" strategy -- raising questions, peppering administrators with comments and hoping an alternative plan surfaces -- to trip up PPIP.

'A Vicious Cycle'

Valuing the toxic assets on banks' balance sheets remains the biggest obstacle confronting the industry. Though estimates vary on the amount of sludge-like securities out there, the government originally thought it would have to consign between $500 billion to $1 trillion to the PPIP program.

Wells Fargo had a blowout first quarter – with help from efforts to pump capital into the system and ease accounting rules. But toxic assets are still a problem for banks.
Associated Press

Regulators worried that a failure to act would have allowed the chain reaction that roiled markets last fall to spiral out of control. The Treasury Department's white paper on PPIP described how the problem cascaded through Wall Street.

The "need to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. As prices declined further, many traditional sources of capital exited these markets, causing declines in secondary market liquidity.

"As a result, we have been in a vicious cycle in which declining asset prices have triggered further deleveraging and reductions in market liquidity, which in turn have led to further price declines."

We all know what happened next. Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke promised to use every tool in the government toolbox to unstick the seized-up markets. Congress pressed the Financial Accounting Standards Board to ease mark-to-market rules.

That massive intervention has allowed many banks to paint rosier financial pictures than they might have a year ago.

Take, for instance,
Wells Fargo
WFC -0.37%
& Co. The San Francisco-based bank took $25 billion from the Troubled Asset Relief Program, an amount representing 13.8% of all funds under program, according to the investigative reporting publication ProPublica. Wells hasn't returned any of its TARP money. It also benefited from a nearly $5 billion write-up of assets stemming from the easing of mark-to-market rules.

These measures helped Wells to report a $3 billion profit in the first quarter.

And that's just one bank.
Citigroup Inc.
C 0.71%
is benefiting from $250 billion in government guarantees on its balance sheet.
Bank of America Corp.
BAC -0.19%
received additional TARP money to offset deteriorating assets at Merrill Lynch. General Motors Acceptance Corp. has been forced back to the government trough after private investors took a pass on providing financing.

Good Bank, Bad Bank

To be sure, those steps have brought a measure of stability to Wall Street, as evidenced by the more than $65 billion in capital raised by banks this spring.

But when it comes to dealing with the culprit, the cancer, the faulty house -- those measures are purely damage control. They are not designed to repair or rid the banks of hundreds of billions in toxic loans.

Wall Street and regulators need to create a fair and transparent system for dealing with toxic assets. It may be that the government requires bank participation in PPIP, or that assets not auctioned will be assigned a value by an independent party. Breaking institutions or the industry into a "good bank" and "bad bank" is still the route favored by some.

Without a plan, the banking system may whistle along, posting suspect profits and clinging to worthless assets, but it's dangerous living. Small banks, which desperately need to value and sell junk, could fail. Their failure could be the new spark that sets an uncontrollable fire through the system.

PPIP may have been a stalking horse, a slow-to-develop government program aimed at freezing the market until confidence returns. At some point, however, a stockpile of combustible materials will not be denied.